Deciding to pay off a car loan early depends on a number of factors, but lately, rising interest rates have made it more appealing than ever.
Since late 2021, the average annual percentage rate on new car loans has surged from 4.1% to 7.1%, according to the most recent data from Edmunds.
For used cars, financing costs are steeper, with average rates climbing from 7.4% to 11%. These rates can be even higher for borrowers with poor credit scores.
Such rates have pushed vehicle loans closer to what's commonly considered high-interest debt — generally, any debt with an interest rate higher than 6% to 8%.
If the interest rate on your auto loan is within that range, or exceeds it, here's why it might be a smart move to work toward paying it off early.
Why high-interest vs. low-interest debt matters
The distinction between high- and low-interest debt is important. If you only have low-interest debt, such as a student loan, financial experts may recommend putting your money into other priorities first, like investments or savings, rather than paying the loan off early.
That's because of opportunity cost: When the annualized return on investments or savings exceeds the interest rates on debt, you end up making more money than you owe.
The S&P 500 index has had average annual returns of 7.28% over the past 25 years, according to Bloomberg data. Those returns aren't guaranteed, of course, but they've typically been higher than the average APR on a new car loan. That being the case, you'd earn more each year putting extra cash into an S&P index fund than you'd save in interest by increasing your monthly auto loan payments.
However, average interest rates have changed: Now that auto loan rates are much higher, the amount you'd be able to earn in the market wouldn't outweigh how much you'd lose to interest on your loan.
"High-interest debt in my mind is anything 6% or above," says Kevin Brady, a certified financial planner in New York. This is because low-risk Treasury bills are hovering between 5% and 5.5%, he says.
For that reason, you may be better off paying down your auto loan as quickly as you can, unless you have other debt with even higher interest rates to pay off, like credit cards.
"I encourage people to pay off car loans early if their interest rates are higher than 5%," says Byrke Sestok, a CFP in New York. "Right now, the best high-yield savings accounts offer around 5% APR and a pragmatic long-term investment return from a balanced investment portfolio is 6% to 8%."
Not a 'one-size-fits-all solution'
While it might feel weird to put extra money into a depreciating asset like a car, you avoid paying more in interest the quicker you pay off the loan. Plus, paying off an auto loan early will increase your monthly cash flow, which can be put into investments or savings.
That said, the decision to pay down your car loan is not a "one-size-fits-all solution," says James Allen, a CFP in Los Angeles.
Some loans come with prepayment penalties that could offset the interest savings from an early payoff, he says.
And if you don't have another type of installment loan open, paying off your loan could limit your credit mix and potentially lower your credit score. In that case, paying off the loan early might not be worth the bother if you're planning a big purchase, like buying a home.
Also, if you don't have an emergency fund — typically three to six months worth of expenses — you should consider topping that up before you pay off the loan, especially if your monthly cash flow is stable.
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